Financial crisis has left 401(k)s vulnerable, so what now?

As the father of two college-age kids, Rob Harris knew that finding money to pay soaring tuition costs wasn’t going to be easy. Reluctant to saddle himself or his children with loans, the 55-year-old product development manager from Kansas City, Mo., tapped another source: his retirement savings.

As the father of two college-age kids, Rob Harris knew that finding money to pay soaring tuition costs wasn’t going to be easy. Reluctant to saddle himself or his children with loans, the 55-year-old product development manager from Kansas City, Mo., tapped another source: his retirement savings.

Harris plans to pay himself back, but his decision to prioritize his kids’ education is at least partly responsible – along with rising health care costs and a sluggish stock market – for pushing his target retirement age from 59 to 62.

“Everyone says you shouldn’t do it, but there were several years the market was a big loss. You’ve got money there, you’ve got a real need, why not use it?” he said.

Harris is among a growing number of Americans who are dipping into their 401(k)s and other defined contribution plans to pay for more immediate needs such as tuition, overdue bills, credit cards and mortgages.

One in four American households withdraw a total of more than $70 billion from 401(k)s or similar retirement savings plans for non-retirement spending needs every year, according to a report published this month by the financial advisory firm HelloWallet.

With traditional pensions fading into memory, and Congress considering cuts to Social Security and Medicare, many Americans working in the private sector expect their 401(k) nest eggs to guarantee financial security in their older years. But in the aftermath of the Great Recession, increased “leakage” from 401(k)s in the form of cash-outs, hardship withdrawals and loans is worrying policymakers and retirement savings experts, who also bemoan the plans’ high fees and stubbornly low participation rates. Some are looking for ways to reform 401(k)s, or even offer innovative alternatives.

One such plan has been proposed by Teresa Ghilarducci, an economics professor at The New School in New York City and an ardent critic of 401(k)s.

“A good pension plan helps people accumulate money, helps them invest money appropriately, and helps people pay out your pension for life, and the 401(k) fails at all three of those dimensions,” Ghilarducci said.

Her plan would require that employers deduct 2.5 percent of their employees’ pay, a contribution that businesses could match if they chose. Employee contributions would be mandatory. The money would be set aside in a fund that pays a guaranteed, modest rate of return to supplement Social Security. The return could be guaranteed by a paid fund or an insurance company, and it would be paid out after a worker retired in the form of an annuity for the rest of that person’s life.

“What people put in and what they earn is what they’re going to get out, so it’s a safe and secure savings account that’s only there for retirement purposes,” Ghilarducci said.

California already has moved to adopt a voluntary version of Ghilarducci’s plan that would pool contributions from private-sector workers in a state-administered, professionally managed fund. The state is awaiting a feasibility study and a final vote by the legislature before launching it by the end of 2013. Other states exploring the possibility include Connecticut, Rhode Island, New York and North Carolina, Ghilarducci said.

Ghilarducci would like to see a plan like hers adopted at the federal level, but “Congress does not have an appetite for a bold social program,” she said.

Last year, Sen. Tom Harkin, D-Iowa, floated the idea of privately run pension plans he calls USA Retirement Funds. Workers without a pension or a 401(k) would be able to make automatic contributions toward retirement through pre-tax payroll deductions. Businesses would be required to contribute as well but would receive tax credits to offset the cost. Workers would receive regular payments from the funds throughout retirement, like a pension. The proposal hasn’t made much headway.

Whatever politicians ultimately come up with, 401(k)s aren’t going anywhere anytime soon, said David John, a senior research fellow in retirement security and financial institutions at the conservative Heritage Foundation.

“There is always a temptation – and this is especially true in Washington – to completely rewrite the system and specify every detail of it, but the fact is that although the 401(k) system is imperfect in many ways, it’s a vibrant, active system,” he said. A government-specified program, he added, wouldn’t have the same vibrancy and would be tough to pass against industry opposition.

Instead, policymakers can take smaller steps to improve the Individual Retirement Account/401(k) system, John said.

To discourage people from tapping their retirement savings, policymakers could make it easier for old 401(k) balances to be automatically transferred to a person’s new employer. This would reduce cash-outs when people change jobs, he said.

Policymakers could help people save more through a mechanism called automatic escalation, which would move up the proportion saved from a worker’s income by 1 percent a year, John said. “This is something that exists right now and we have a certain number of companies that are doing that. We don’t have enough,” he said.

John also would like people to receive monthly statements from their plans showing how much income they can expect to see at retirement, so they can plan better.

For now, though, 401(k)s remain “as good a place as any” to save, as long as investors don’t treat the plans as rainy day funds, he said. The success of 401(k)s depends on long-term investment. Those who make pre-retirement withdrawals get hit with big tax penalties, plus they lose whatever they would have earned in interest. “Keep saving, save throughout your career, and don’t touch the money,” John advised.

Created by Congress in 1978, 401(k) plans were intended to supplement traditional pensions and Social Security. Now they are the most widespread private-sector, employer-sponsored retirement plans in the United States. In 2011, the 401(k) system held $3.2 trillion in assets on behalf of 51 million American workers.

Experts recommend saving at least enough to qualify for an employer match every month, usually a minimum of 6 percent of your paycheck if the match is 3 percent. But even counting on Social Security, you probably need to be saving 12 percent to 15 percent to replace 80 percent of your pre-retirement income if you don’t have a traditional pension plan, said Diane Oakley, executive director of the National Institute on Retirement Security.

Most Americans don’t even come close. Only half have any retirement savings at all.

A 2006 law tried to boost those numbers by making it easier for businesses to automatically enroll employees, but coverage remains low. Bureau of Labor Statistics data show that 37 percent of civilian workers in the United States participate in a defined contribution plan such as a 401(k) or an Individual Retirement Account.

Those Americans who do participate in 401(k)s are contributing less and draining their savings more, leaving the typical household approaching retirement with $120,000 in 401(k) or IRA holdings, according to a 2010 survey by the Center for Retirement Research at Boston College. For a retiree, that works out to only about $575 in monthly payments.

“We haven’t really seen how 401(k) plans are going to translate into providing people with a lifetime income of retirement,” Oakley said.

The government’s focus on encouraging or increasing 401(k) deposits misses the economic reality of many Americans’ lives, she said.

“Individuals know they’re important, but they’re also in a situation where economically their families are pressed at all ends, and too often we save for retirement with the last dollars we have left,” Oakley said.

Harris doesn’t regret withdrawing a few thousand dollars from his retirement fund to help send his kids to college. He figures he’s still in pretty good shape because he’s vested in his employer’s pension, will receive Social Security benefits, and has been saving between 6 percent and 12 percent of his paycheck in his 401(k) for years. He knows others aren’t so lucky, though, and he worries about his children’s retirement prospects.

“I think the 401(k) becomes more important now than when I got out of school,” he said. “Now pensions are gone, so I think it puts more responsibility on the individual.”